Our Insights

Building CCP resiliency

The evolution of CCP guidelines

While reform of the over–the-counter (OTC) market was necessitated after 2008, post-crisis regulations have resulted in an unprecedented amount of risk being concentrated in just a handful of central counterparty (CCPs) clearing houses.1 This consolidation of risk prompted regulators to further analyze the interdependencies between CCPs and their clearing members, many of which are large banks. These banks supply a number of financial services to CCPs, such as liquidity provision, lines of credit, custody, settlement, and cash management on a cross-border basis.2

In August 2018, a coalition comprising of the Financial Stability Board (FSB), the Committee on Payments and Market Infrastructures (CPMI), the International Organization of Securities Commissions (IOSCO) and the Basel Committee on Banking Supervision (BCBS) published their findings on the interdependencies between CCPs and their clearing members.3

Key insights

  • To mitigate against a CCP failure and the potential contagion effect on market stability, regulators have provided further guidance for consideration
  • While risk waterfalls at CCPs were put to the test in 2008, regulators want further assurances that these infrastructures are protected against systemic risks given the exponential increase in centrally cleared OTC volumes
  • The study highlighted the interconnected nature of this sector: 90 percent of pre-funded financial resources were concentrated in just 10 CCPs, with the two biggest clearing houses accounting for 40 percent of that total

Risks laid bare

The study, which assessed 26 CCPs across the Americas, Europe, and Asia-Pacific, found the largest 11 clearing members, out of a total of 306, were connected to between 16 and 25 CCPs.4 “This indicates that the default of a CCP's clearing member could result in defaults of the same entity or affiliates in up to 24 other CCPs included in this analysis," noted the report.5 Further commentary highlighted that 90 percent of pre-funded financial resources were concentrated in just 10 CCPs, with the two biggest clearing houses accounting for 40 percent of that total,6 although it is an improvement from 2016 when just one CCP held the majority share of client margin.7

The interdependencies referenced above matter to regulators as the failure of a systemic institution, irrespective of whether it is a CCP or a clearing member, has the potential to trigger a contagion effect, and market-wide instability.

CCP failures do happen...but rarely

CCPs have failed in the past, most notably Hong Kong Futures Exchange Clearing House, which collapsed in 1987 as a result of the global equity market crash.8 CCPs do, however, have multiple risk waterfalls to insulate themselves against extreme volatility and clearing member(s) failures, including margin, default fund contributions from a defaulting member, the CCP's own proprietary capital, and default fund contributions from non-defaulting clearing members.9

CCPs are dependent on a small number of firms for core banking services, with 22 out of 26 CCPs exposed to at least 10 global systemically important financial institutions

The risk waterfall structure was thoroughly tested during the financial crisis when Lehman Brothers' USD 9 trillion interest rate derivatives portfolio at its CCP, LCH, consisting of more than 65,000 trades, was successfully closed out in three weeks using one-third of the failed bank's initial margin held at the CCP, suggesting that the existing risk management processes at these infrastructures are incredibly robust.10

CCPs and bank service providers

CCPs are dependent on a small number of firms for core banking services, with 22 out of 26 CCPs exposed to at least 10 global systemically important financial institutions.11 The report said it was not uncommon for the largest clearing members to provide at least three different critical sets of services to CCPs, while one institution was quoted in the findings as offering six separate services.12

A default at a core bank counterparty would be felt across multiple organizations, particularly if that financial institution was a member of one CCP, and a custodian to another, while simultaneously providing a credit line to a third.13 Such an event would cause massive operational disruption to the impacted CCPs, and in extremis could even precipitate the collapse of a CCP.

Making the system safer

While robust risk waterfall frameworks are in place at CCPs, regulatory bodies continue to closely assess
risk in the context of
ever-changing financial
markets

While robust risk waterfall frameworks are in place at CCPs, regulatory bodies continue to closely assess risk in the context of ever-changing financial markets. Guidance from CPMI and IOSCO, published in 2017, provided further clarity in areas such as credit and liquidity stress testing, margin practices, prefunded loss absorption capacity or coverage, recovery planning14 and details on the treatment of non-default losses caused by an operational problem or cyber-incident.15

Regulators including the FSB are particularly keen for CCPs to develop living wills detailing how they would be wound down were a credit event to deplete or eliminate their default fund contributions and capital. The recommendations from the FSB broadly mirror the requirements already imposed on systemically important banks and insurers.16 Meanwhile, the European Securities and Markets Authority (ESMA) is moving forward with its own CCP Recovery and Resolution proposal, which calls on Member State regulators to create CCP resolution plans.17 With the migration of increased OTC volumes into clearing, it is pivotal that regulators ensure these market infrastructures can withstand sudden shocks and disruptive events.

 

 

You may also like